Chapter 7. Assignment of Income

Transcription

1 Chapter 7. Assignment of Income A. Transfers Incident to Marriage and Divorce 1. Introduction: When a couple marries, they are entitled to file a joint return, and if such a return is filed the parties need not decide whether income of the couple should be allocated to the husband or to the wife. But upon dissolution of the marriage, this issue becomes important because the (former) couple cannot file a joint return. Yet, because of continuing legal relationships arising out of the marriage, in many ways the (former) couple constitute a single unit for consumption. Further, expenses likely increase as one household becomes two. 2. Property Settlements a. Transfers Incident to a Divorce or Separation Agreement i. United States v. Davis (p. 291): Incident to divorce, the taxpayer transferred appreciated property to his wife in exchange for her release of all marital claims. The court held (a) that such an exchange is taxable under section 1001(a) and (b) that when the value of the property received cannot be valued it is appropriate to assume (in an arms-length transaction) that value of the assets exchanged are equal. ii. The second holding of Davis has been overruled by Under 1041, the transfer of property between spouses during the marriage, within one year after the end of the marriage, or even longer is related to cessation of the marriage, is tax-free to the recipient spouse, 1041(b)(1), and basis carries over, 1041(b)(2). Note that these rules apply even if the property transferred is encumbered. iii. Problems (p. 296): (A) Problem 1: (1) Part (a): No gain recognized and basis in the note equals $200,000 (that is, payments on the note can be received tax-free). (2) Part (b): Henry s basis in the house remains at $100,000. (3) Wilma would recognize gain of $150,000 (amount realized less her half of the basis), and Henry s basis would increase to $250,000 (his half of the original basis plus additional cost of $200,000). (B) Problem 2: Yes, but only because of the special rule in 121(d)(3)(B). Without that provision, would not qualify for the provision because the house had not been her principal residence for any part of the 5-year period ending on the date of sale. 80

2 b. Antenuptial Settlements: i. Farid-Es-Sultaneh v. Commissioner (p. 296): This case looks at the same issue decided in Davis but from the perspective of the recipient spouse, and it concludes that the receipt of property in exchange for a release of marital rights is tax-free. Since there seems no plausible argument that the recipient has any positive basis in the surrendered marital rights, there seems no principled way to reach the result adopted by the court. ii. This result has now been codified by 1041(b)(1). iii. Questions (p. 299): (A) (B) Question (1): Under Davis, Kresge had a recognized gain in 1924 based on the excess of the value of the stock over his adjusted basis in that stock. Section 1041 would not have applied to the transfer because they were not yet married to one another. Today, such a contract should provide for the transfer at the earlier of the marriage or death of the transferor. Question (2): It is hard to find a reason why receipt of the payments should not have been taxable to Farid-Es- Sultaneh; indeed, without such taxation it is impossible to explain her cost basis in the stock she received. 3. Alimony, Child Support, and Property Settlements a. Basic Taxation i. "Alimony" within the meaning of 71 is includible to the recipient. 71(a). ii. iii. Such alimony is deductible by the payor. 215(a). Note: If you assume that the payor will fund the alimony payments out of current wages, then the scheme of 71(a) and 215(a) operates to tax wages paid as alimony to the ultimate recipient rather than to the wage earner. That is, the wage earner includes the wages and then deducts the alimony, for a wash, and the recipient has net inclusion. b. Relationship of 71 to 1041: Observe that there is little overlap between 71 and 1041 because 1041 deals only with the gain or loss on property transferred between spouses (and between ex-spouses) while the definition of "alimony" in 71 requires that it be in cash. Because the transfer of cash can never produce gain or loss to the transferor, 1041 can never be implicated in an alimony transferor. However, 1041 provides that the recipient has no income on the receipt of property from a spouse or ex-spouse (under certain conditions). This conflicts with the rule of 71 providing that the recipient spouse must include all "alimony" received. Thus, we must either interpret "property" in 1041 as excluding cash or interpret 71 as preempting 1041 to the extent they overlap. I think it clear that 71 preempts 1041 when both apply. c. Definition of Alimony: i. Must be in cash. 71(b)(1). 81

3 ii. Payments must be made pursuant to a divorce or separation decree or a written agreement. 71(b)(1)(A), (b)(2). iii. The agreement must not specify that the payment is nondeductible. 71(b)(1)(B). (Note that this provision allows the parties to specify that what otherwise would be includible to the recipient and deductible by the payor shall instead be non-includible and non-deductible. What facts should guide that decision?) iv. The obligation to make payments must terminate at the death of the recipient. 71(b)(1)(D). Note: the payments can also terminate for other reasons if the parties desire. v. The payment is not "child support" within the meaning of 71(c). Such "child support" includes amounts specified in the agreement as child support as well as other amounts which, by the terms of the payments, are for the support of the children. E.g., payments terminating on the death or marriage of a child will be treated as child support. See 71(c)(2). 4. Excess Front Loading 71(f): Overview: If a disproportionate amount of the alimony is paid during the first two post-separation years, the payor ex-spouse will be required to recapture some of the prior deduction by including it in current income. To the extent that the payor ex-spouse recaptures some of the prior deductions, the recipient ex-spouse may deduct the same amount. 71(f)(1)(B). You are not responsible for computations under 71(f). 5. Problems (p ): a. Problem 1: No deduction for Winifred and no inclusion to Max because "alimony" within the meaning of 71 must be incorporated in a writing (an "instrument"), 71(b)(1)(A). b. Problem 2: The payments are "alimony" and so will be includible by the Wanda and deducible by Manuel each year. In addition, there be recapture in year 3 under 71(f). c. Problem 3: Because the payments do not terminate upon the death of the recipient spouse, the payments are not "alimony" ab initio. 71(b)(1)(D). The insurance premiums do not suffer from this defect but the premiums do not seem to be received by or on behalf of W as required under 71(b)(1)(A). But see Temp. Regs T (A-6 and A-7) seemingly allowing such premiums to be treated as alimony. d. Problem 4: The payments are "child support" as described in 71(c)(1) by virtue of 71(c)(2)(A). e. Problem 5: The transfer of shares cannot be "alimony" because the shares are not in cash. But for application of 1041, Nancy would recognize gain of $9,000 on the transfer. However, 1041 treats this transaction as a gift, so that Nancy recognizes no gain and John takes a carryover basis in the stock of $1,000. Accordingly, John should decline to accept the stock in lieu of $10,000 in cash: why take low basis stock rather than high basis cash? This problem points out that in dividing property incident to a divorce, the parties must not only ensure that each gets equal value but also that each gets equal basis. If 82

4 one party accepts low basis property, he or she should demand more value. 6. Diez-Arguelles v. Commissioner (p. 304): Should the taxpayer be entitled to a deduction for child support payments not received? In answering this question, note that child support payments are not includible by the recipient. i. In general, no deduction is proper when a taxpayer fails to receive taxable income. This result can be explained either as netting the taxable receipt against the deduction or as allowing a deduction only to the extent of the taxpayer's basis in the claim, and that basis is zero. ii. In Diez-Arguelles, the receipt itself would have been tax-free. Should that change the result? Surely the taxpayer would not be entitled to a deduction if the divorce court simply failed to award child support. Is the actual case fundamentally different? For determining vertical equity, what is a similarly-situated taxpayer? iii. Note that allowing a deduction to the taxpayer in this case requires nothing more than allowing the taxpayer to use an accrual method of accounting rather than the cash method with respect to the child support. iv. Note 1 (p. 306): (A) (B) Ann recognizes gain of $9,000 on the transfer of the shares to Bob. Bob takes a cost basis in those shares of $10,000, so Bob recognizes a loss of $1,000 on a subsequent disposition for $9,000. (N.B.: we are assuming that 1041 does not apply to these facts.) Bob had no income on receipt of the shares because child support is not taxable. When Ann defaults on the loan, she will have Kirby Lumber income of $10,000, and Thelma will have a bad debt deduction under 166(d) in the same amount. (We need more facts to know whether Thelma should treat this as a business bad debt or as a nonbusiness bad debt.) When Bob sells the stock for $9,000, he realizes a loss of $1,000. He did not have income on receipt of the cash used to purchase the stock because child support is not taxable. (C) Ann's estate will have Kirby Lumber income of $10,000. Bob will have a nonbusiness bad debt of $10,000 (assuming he is not in the business of making loans). Bob had no income on receipt of the cash because child support is tax exempt. (D) This is the issue posed by Diez-Arguelles. (Note that 166(e) does not apply because a note received from an individual is not a "security" for purposes of 166(e).) It seems clear that Bob should have a bad debt here, but that assumes that Bob now has a basis of $10,000 in the note. Does he? Diez-Arguelles seems to 83

5 say that he does not. Note that if Bob had been an accrual taxpayer, presumably even the Tax Court in Diez-Arguelles would have permitted the bad debt deduction. Since cash accounting should only affect timing and not amount of income, does not this further suggest that the case was wrongly decided? Does Ann's estate have Kirby Lumber income? She should, although if Bob has no bad debt deduction, it seems inconsistent to say that Ann's estate has income. (E) Bob must have a loss of $1,000 on the sale of the note. (Why?) Thelma takes a cost basis in the note of $9,000, so she has a bad debt deduction of $9,000 when Ann dies. Ann's estate has Kirby Lumber income of $10,000. v. Note 2(b) (p. 307): Because the judge was a man? B. Attribution of Earned Income: 1. Lucas v. Earl (p. 554): The taxpayer and his wife agreed to be equal partners with respect to all their income and property. During the taxable year, the taxpayer earned a salary. At issue was the taxation of that salary: should it be reported entirely by the taxpayer or half by the taxpayer and half by his wife. a. Was any revenue at stake? Yes: since we have progressive tax rates, dividing income between two (or more) taxpayers can reduce the overall tax liability. That is, the tax on 2X dollars is more than twice the tax on X dollars. b. Did the Supreme Court find that the contract between the Earls was entered into to avoid tax? No: they signed the contract in 1901, and the first constitutional income tax was enacted in c. If there was no bad motive on the part of the taxpayers, and assuming (as the Court did) that the contract was fully enforceable, why was the income taxable entirely to Mr. Earl? Because the incidence of earned income cannot be shifted by an anticipatory assignment of the right to receive the income. d. Note Rev. Rul , discussed in Note 5 (p. 556). The taxpayer has contributed services to an exempt organization but as to which contributions are not deductible (that is, it is an exempt organization but not a charity described in 501(c)(3)). Should income be imputed to the service provider? 2. Poe v. Seaborn (p. 557): The taxpayer and his wife resided in a community property state. At issue was the incidence of taxation on the taxpayer's salary as well as the profit from the sale of several community assets. a. Consider only the taxpayer's salary income. The Supreme Court says that half of it was properly taxable to each spouse because "the use of the word 'of' [in 61] denotes ownership." Yet, who owned (i.e., had the legal right to) Mr. Earl's salary? Surely an enforceable contract can transfer ownership as well as a community property statute. b. This case, in distinction to Earl, concerned nonconsensual splitting of income. Does that mean that abuse is unlikely? No: several states changed their property laws to a modified form of community property 84

6 in order to exploit Seaborn. Congress obviated the need for such changes in 1948 when it allowed spouses to file jointly (i.e., aggregate income) on a joint return. c. Note that Earl was retail splitting (by contract) while Seaborn was wholesale (by public law). Where does the greatest potential for abuse lie? See Note 2 (p. 560). d. Note the reaffirmation of the holding of Poe v. Seaborn in Commissioner v. First Security Bank of Utah, discussed in Note 3 (p. 560). 3. The Marriage Penalty (p ): The following policy concerns cannot be implemented simultaneously: (1) progressive marginal rates; (2) no marriage penalty (that is, a married couple's tax liability will not exceed the combined tax liability if they were unmarried); and (3) couple equality (that is, the tax burden paid by a married couple is determined by how much the couple jointly earns and is unaffected by how much each member of the marital community earns separately). Currently, we have a marriage penalty for some taxpayers who each have substantial taxable income and a divorce penalty for those couples composed of one taxpayer who has little or no income of his or her own. C. Attribution of Unearned Income: 1. Blair v. Commissioner (p. 570): The taxpayer's father devised the taxpayer a life income interest in a certain trust. The taxpayer gifted to his daughter the right to $9000 of the trust income each year. At issue was whether the taxpayer or his daughter should be taxed on that $9000 annual amount. The Supreme Court held that (1) the daughter should be taxed on the theory that the daughter became a part owner of the trust and (2) income from property (such as the trust corpus) should be taxed to the owner of the property. 2. Helvering v. Horst (p. 572): The taxpayer made a gift of a bond interest coupon just prior to the coupon's maturity. At issue was whether the taxpayer or the donee should be taxed on the interest income. a. Did the Supreme Court hold that the taxpayer was taxable when he made the gift or when the coupon was cashed? Despite some sloppy language (at p ) to the contrary, it held that the taxpayer was taxed when the coupon was cashed. b. How did the Court distinguish Blair? See p. 650 (gift of property versus gift of income from property). Note, though, that one could reasonable argue (as did Justice McReynolds in dissent) that a bond coupon is "property" as much as anything else. c. The Blair case is said to involve a "vertical" slice of property (part of the income from the property for as long as the property exists) while the Horst case is said to involve an "horizontal" slice (all of the income from the property for a fixed period of time). 3. Variations: a. Suppose that the taxpayer in Horst had given away all of the coupons to various relatives and had kept the stripped bond. Who would be taxable on the annual income? What if the taxpayer also gifted away the stripped bond? What if he gave it to a charity? 85

7 b. Suppose that F leases Blackacre for 9 years and then immediately subleases it to a third party for $10,000 per year. Who should be taxed on the annual rent if F gives the right to the first year's rent to his son? What if he gives the right to all nine years' rent to his Son? What if he waits 7 years and then gives the right to the remaining 2 years' rent to his son? c. An alternate approach would be to treat all rights to income as "property" and then tax each party under the usual ( 61, 1001, 1012, 1015) rules. For example, the following chart sets forth the various values of a 3 year, 12% bond which sells for its face value of $1000. Start Year 1 Year 2 Year 3 Coupon 1 $ $ Coupon $ Coupon $ "Bond" Total $ $ $ $ i. Problems: (A) Suppose Father gives coupon 1 to Son as soon as Father purchases the bond. How should they be taxed at the end of year 1? Son should take a carryover basis of $ in coupon 1, so that at the end of the year, he should be taxed on $ $107.14, or $ Father, on the other hand, should be taxed on the implicit interest on coupon 2, coupon 3, and the principal amount. That implicit interest equals ($ $95.66) + ($ $85.41) + ($ $711.78), or $ It is no coincidence that the total interest under this method equals $120.00, precisely what would be taxed to Father if he had not gifted coupon 1. That is, we are allocating the year's taxable income, not creating any taxable income. (B) Suppose that Father gives coupon 2 to Son as soon as Father purchases the bond. How should they be taxed? At the end of year 1, Son should be taxed on the implicit interest on coupon 2, or $ Father should be taxed on the explicit interest on coupon 1 [$12.86], plus the implicit interest on coupon 3 [$10.25] and the principal [$85.41], for a total of $ At then end of year 2, Son should be taxed on the amount he receives ($120.00) over his adjusted basis in coupon 2 (original carryover basis of $95.66 plus adjustment for implicit interest already taxed of $11.48), or $ $107.14, or $ Father should be taxed on the implicit interest on coupon 3 and on the principal, or $

8 ii. (C) Suppose Father gives coupon 2 to Son at the end of year 1. How should they be taxed? At the end of year 1, Father should be taxed on $120.00, that being the explicit interest on coupon 1 plus the implicit interest on coupon 2, coupon 3 and the principal. Son will take a basis in coupon 2 of $107.14, that being Father's original basis in coupon 2 plus the implicit interest on coupon 2 already taxed. Thus, at the end of year 2, Son should be taxed on $12.86 and Father should be taxed on $ Implicit Interest and the Realization Doctrine: (A) In what sense is implicit interest the opposite of depreciation? Implicit interest represents the inevitable increase in the value of a future income stream, ignoring any changes in value due to market conditions. (B) Is it inappropriate to tax the bondholder on his implicit interest when he receives no (current) cash? Surely this method is more fair than Horst, where the bondholder was forced to pay tax on the full $ interest without receiving any cash. (C) Note that this scheme treats a bond just like annuities should be taxed. Indeed, why is a bond not just a fixed-term annuity with a balloon payment at the end? From that perspective, should not some of the cost of the bond be allocated to coupon 1 as basis in coupon 1? (D) Is Irwin v. Gavit relevant? If so, how should Horst have been decided? How should Father be taxed if he strips the coupons and immediately sells the naked bond? 4. Helvering v. Eubank (p. 578): This case protects the integrity of the earned income branch of the assignment of income doctrine by holding that the right to earned income cannot be called "property." Yet, some part of what was given by the taxpayer in Eubank to his daughter is appropriately thought of as unearned income, and the incidence of taxation on unearned income can be shifted by assigning the underlying property. Blair. a. Assume that there will be $1,000 in renewals if all policy holders renewed. Assume further that the value of the insurance salesman efforts in selling the policies was $600; that is, if he had been paid cash rather than in uncertain renewals, he would have been paid $600. Lastly, assume that the present value of the renewal rights as of the time when they were earned was $750. b. From these facts, we can determine that the $1,000 ultimately to be collected as renewals can be divided into three amounts. Six hundred represents the value of the agent's labor; $150 represents the risk associated with nonrenewal; and $250 represents the time value of money. c. It seems clear under Earl that at least $600 should be taxed to the insurance agent. It seems equally clear under Blair that at least $250 87

9 should be taxable to the assignee. The remaining $150 (representing risk of nonrenewal) arguably could be considered earned income (the better the sales job, the more likely a renewal) or as unearned income (risk of default usually is part of interest). d. When should Eubank be taxed? Presumably when his daughter collects the renewals. Horst. D. Non-Gratuitous Assignments of Income: 1. Cotlow v. Commissioner (Supp. 1955): This case is just like Eubank except that the insurance agent sold (rather than gifted) his right to future commissions. At issue was whether the purchaser of those rights is taxed on receipt or whether the insurance agent is taxable on them. Held, the purchaser is taxable. a. Is the abuse to which the assignment of income doctrine speaks present in this case? No: since the assignor (the insurance agent) received taxable proceeds on the sale, no earned income is shifted to a lower bracket taxpayer. b. Note that the purchaser will collect more than he paid for the commissions. Since that excess would have been taxable to the insurance agent but for the assignment, is there not a potential for abuse? No: that excess represents compensation for (1) deferred collection of the commissions in the future and (2) bearing the risk that the policies will not be renewed. That is, it is interest income. Such unearned income should be taxed to the owner of the property producing it, and in the case of interest income, that is the person who owns the debt (and who is waiting for repayment). In this case, that is the purchaser. The insurance agent has been paid the discounted and risk-free value of his services, and that is all to which Lucas v. Earl speaks. c. One way to explain this case is by saying that courts will not draw the line between the earned and unearned component of a future income stream, but when the market draws that line, the courts will follow it. In this sense the assignment of income cases are similar to Irwin v. Gavit. Note, though, that in Gavit the assignee of the income interest was given too little basis while in Horst the assignee of the income interest was given too much. 2. Estate of Stranahan v. Commissioner (Supp. 1973): The taxpayer sold the right to $122,820 in future dividends to his Son for an immediate payment of $115,000. How should they be taxed? a. Note that the excess of what the Son will receive over what he paid is nothing but interest on a future income stream. Father has already been taxed on the present value of that stream. b. How should they be taxed if Son had paid only $50,000 even though the fair market value of the right to $122,820 had been worth $115,000? i. Conceptually, we should tax Father on the accrued (i.e, present value of the) dividends, or $115,000, regardless of what Son pays. The additional $7,820 should then be taxed to Son as interest on his (partially purchased, partially received as a gift) capital. 88

10 ii. iii. If, though, we try to apply Horst and Stranahan, then presumably we ought to bifurcate the transaction into a gratuitous component (controlled by Horst) and a nongratuitous component (controlled by Stranahan). Because the fair market value of the future dividends equals $115,000 while the gross value to be received equals $122,800, the difference of $7,820 should be treated as interest on the present value of $115,000. Of that $115,000 principal amount, $50,000 is Son's money and the remaining $65,000 is Father's money (under Horst), so presumably Son should be taxed on 50/115 of the interest and Son should be taxed on 65/115 of the interest. In round numbers, that means that Son should be taxed on about $3,400 of the interest while Father should be taxed on about $4,400 of the interest as well as on the $115,000 present value of the dividend stream. Note that Father will be taxed on $50,000 when he receives the money from Son and on the additional $69,400 when Son receives the dividend payment. The following chart summarizes this discussion. (A) The first column displays the analysis if the father makes a gift of the dividends to the son. Conceptually, the father should be taxed on the present value of the dividends ($115,000 at the bottom of the chart) and the son should be taxed on the time value of money on that amount (the dark $7,820 at the top of the chart). However, under Horst the entire amount of $122,820 is taxed to father when the dividends are received by the son. (B) The third column displays the analysis if the father sells the dividends to the son for fair market value of $115,000. Father is taxed on the $115,000 sale proceeds and son is taxed on the $7,820 time value of money increase. Stranahan. (C) The middle column displays the proposed analysis if father makes a part gift/part sale to son by selling the dividend (currently worth $115,000) to son for only $50,000. The father will be taxed on the sale proceeds of $50,000 under Stranahan, on the remaining $65,000 of present value of the dividends under Horst because he (father) keeps the underlying stock, the son will be taxable under Stranahan on $3,400, that being the time value of money increase of the purchased portion of the dividends under, and father will be taxed under Horst on $4,400, that being the time value of money increase on the gifted portion of the dividends. Whether a court would actually do this is anyone's guess. I think son should also be taxed on the $4,400, 89

11 but that seems to me to be counter to Eubank and to Horst. 90